Canadian National Railway Co (NYSE:CNI) Q2 2018 Earnings Conference Call July 24, 2018 4:30 PM ET
Paul Butcher - VP, IR
Jean-Jacques Ruest - Interim President, CEO, Executive VP & CMO
Michael Cory - EVP & COO
Ghislain Houle - EVP & CFO
Kenneth Hoexter - Bank of America Merrill Lynch
Cherilyn Radbourne - TD Securities
Allison Landry - Crédit Suisse
Fadi Chamoun - BMO Capital Markets
Jason Seidl - Cowen and Company
Brandon Oglenski - Barclays Bank
Christian Wetherbee - Citigroup
Walter Spracklin - RBC Capital Markets
Scott Group - Wolfe Research
Turan Quettawala - Scotiabank
David Vernon - Sanford C. Bernstein & Co.
Ravi Shanker - Morgan Stanley
Benoit Poirier - Desjardins Securities
Seldon Clarke - Deutsche Bank
Thomas Wadewitz - UBS Investment Bank
Brian Ossenbeck - JPMorgan Chase & Co.
Welcome to CN Second Quarter 2018 Financial Results Conference Call. I would now like to turn the meeting over to Paul Butcher, Vice President, Investor Relations. Ladies and gentlemen, Mr. Butcher.
Thank you, Patrick. Good afternoon, everyone, and thank you for joining us for CN's Second Quarter 2018 Earnings Call.
I would like to remind you about the comments already made regarding forward-looking statements. Before I introduce the speakers on the call today, I would first like to congratulate J.J. Ruest on his nomination as President and CEO of CN. I have known J.J. for over 20 years, and I'm very honored to work under his leadership. Accompanying J.J. on the call today is Mike Cory, our Executive Vice President and Chief Operating Officer; and Ghislain Houle, our Executive Vice President and Chief Financial Officer. [Operator Instructions].
It is now my pleasure to turn the call over to CN's President and Chief Executive Officer, Mr. J.J. Ruest.
Thank you, Paul. Thank you, and good afternoon, everyone. Welcome to our earnings call. First off, I wanted to say that I'm very honored to be here today with my colleague railroaders, all of us having each 2 decades of building CN from the ground up. Back in March, the Board asked me to act with a sense of urgency, and the team really delivered as one. We produced adjusted EPS growth of 13%, a best-in-class operating ratio of 58.2; revenue growth of 9%, which was from solid same-store price of 4%; and revenue ton mile volume of 7%. We generated nearly $1.3 billion of fresh cash after the first 2 quarters, and we also made good progress on our midterm agenda of development of talent, safety culture and strategic growth to outperform the economy. And it is -- therefore, it is this confidence in our business and confidence in our railroading acumen of the team that we are raising the 2018 guidance. Ghislain will provide the specifics in a few minutes.
Despite a very challenging first quarter, our team of railroaders is definitely not giving up on delivering solid year-end results.
I will now provide an update on our top line followed by Mike's overview of our operations, and Ghislain will follow with financials in our updated guidance.
Demand is currently strong, and the demand outlook for the remainder of this year is strong as well and broad-based. This is why we are working diligently on adding capacity and resiliency to our network. Volume is -- as expressed in revenue ton mile in the last quarter, was up 7%. Same-store price for Q2 was up a solid 4.0%. Sequentially, remember in the last quarter, it was up 2.7%. Core pricing from recent renewal concluded in the last 90 days averaged about 4.4%.
You will recall that same-store price is a backward-looking measure of price on our full book of business as executed in the last quarter. Core pricing from recent renewal is a forward-looking measure of price trend from only the deal concluded in the last 90 days.
On revenue by commodities, coal revenue grew 39%, mainly from Canadian export coal of met coal to Asia and U.S. export coal of thermal coal to Europe.
Grain and fertilizer revenue was up by 12%. Our grain volume was up in both Canada and United States. This year's Canadian crop and carryover looked fairly promising. Our frac sand segment executed in the previous quarter -- exceeded, I'm sorry, our previous quarter record and was driven mostly by strong demand in Western Canada. We see the same outlook in the short term with regard to the frac sand business.
We are constructive about continued volume growth in lumber and in base aluminum volume. Our steel -- on steel, our largest steelmaking account is in the United States.
Crude by rail, the revenue was up compared to last year because of better pricing. In the second half, we will have more capacity. Therefore, we will also be able to execute a bigger book of business of crude. We are taking delivery of 16 new G horsepower locomotive, and that will be helpful to our crude business.
Lastly, on intermodal segment, the revenue grew by 6%. The increase last quarter was mainly traffic related to the Port of Prince Rupert and the Port of Montreal and on domestic revenue, which was also up -- it was especially up on the ramp-to-ramp business with our wholesale account. We did add new shipping line customers at the Port of Vancouver as well as a new shipping line customers at the Port of Prince Rupert.
Concluding on the commercial overview, price trend is up from renewal and also from new business, reflecting tighter supply of transportation capacity. On volume, our growth will follow the completion of our new sidings and new section of double-track capacity.
I will now turn it over to Mike. Mike gives you an update on our operation. Mike?
Thank you, J.J. And even though Butcher beat me to it, I just want to congratulate you on a well-deserved promotion.
We're all very proud and we're honored to work for you and with you. So hello, everyone. I want to first of all, thank the railroaders of CN for their efforts in delivering these results. And it's been in an environment that really is still lacking resiliency when you think about our operation. While we still have work to do, these results show the commitment of this operating team to both our model and especially to our customers. As we stated on our Q1 call, this quarter was centered on catching up on the volume, gaining back the confidence of the customers and sequentially improving our operating metrics in line with reducing cost.
Overall, we saw better operating performance in the quarter where we handled the largest workload in CN history. To put this into perspective, gross ton miles were up 8% versus Q1 '18, and this was 5% greater than the highest workload in our history. And that was recorded in Q1 of '17. Further, our overall workload was 23% higher than during the same period in 2016. Now the importance of this comparison is that in Q2 '16, we have the low point of workload in recent past due to the downturn in demand. And in the 2 years between then and now, the infrastructure has changed very little, especially in the high-growth areas in Western Canada and our Southern region, where we've seen growth as high as 35% in some of these corridors. Outside of winter conditions being behind us, a large factor in our ability to deliver this volume is our hiring and qualifying of operating employees. In the second quarter, over 350 employees qualified as conductors. In the quarter, we hired close to another 900 conductor trainings across our system, and they'll become qualified in Q4.
On the safety front, these new employees have had an impact on our performance. Now safety is a core value with CN, and this leadership team stands united in making the culture the safest in the industry, regardless of the challenge that, that volume growth and that new employees bring. In Q2, our FRA accident ratio increased versus Q1. Although with our commitment to investment and hardening our infrastructure, our mainline accident ratio continues to improve. Our area of increased accidents is within yards. Over 2/3 of the overall accidents are on non-main track, and those are primarily in switching yards. These are lower risk as they generally occur at slower speeds.
In addition, it's where the majority of the work is performed by new employees. Our FRA injury ratio improved over Q1. We're focused on and we're improving our approach to proper onboarding and integration of these new employees. Two various initiatives such as targeted regular interventions, especially with employees with less than two years' experience, we're engaging in the frontline, and that's where the rubber hits the road. As well, we're completing overhaul of classroom and field training programs, and we're working with our union partners to provide on-the-job training with qualified instructors. We fully expect that focus and especially leadership will result in the improvement we seek. And each one of us around this table and out in our vast railroad is committed to making this happen.
So looking specifically at Q2 operating metrics, train speed increased 4% versus Q1, and this in itself drives locomotive utilization, which was up 7%; car velocity, which is up 23%; and terminal dwell, which was down 20%, all versus Q1. And we expect sequential improvements as we take possession of new locomotives and rail cars and more employees become qualified to perform work. And of course, with the completion of our capacity projects in Q4 of this year, we're going to see the resiliency we've not had in the near past as volumes have grown, especially over our busy corridors.
In the past few weeks, we completed the majority of our major work blocks for basic track infrastructure. Most of this work was over our less resilient core mainline between Western Canada and Chicago. Along with some flooding in our Minnesota and Wisconsin corridor, these work blocks have impacted our performance over the last two weeks of Q2 and for the first three weeks of Q3. But we are certainly rebounding as I speak. And if you flip to the next page of my presentation, you'll see an overview of where capacity projects were being built in 2018.
Now growth isn't equally spread across the network. It's prevalent mostly on our Western and Southern regions, and this is where most of the projects are taking place. The projects, and they're an all-time record, are progressing quite well. Five projects are completed, primarily in the Southern region, with one of those being the West. And the majority of the projects will be completed and produce benefits into Q4. Finally, with all the volume growth, the capacity improvements we are making, we're adapting our scheduled operating plan to meet the changing demands. This will ensure our precision railroad model continues to lead the industry in both operating ratio and service offering.
Our design team, with operators in the field, are at work. They're using our precision railroad standards to convert the volume growth opportunity into lower OR and better service delivery. Our focus on scheduling the workload of assets, whether they be car inspectors, locomotives or track capacity, is embedded in our D&A. To put it simply, it works. This focus will produce the right balance of cost and profitable growth as we continue to leverage our precision railroad model. From a quarterly perspective, workload's grown 23% since 2016, and the challenge is to adapt our precision model to this and more as we continue to grow CN's business efficiently.
The mix of business has evolved over this time with more unit trains and more Western Canadian activity with intermodal to the U.S. In addition, we see growth in our branchline feeder systems throughout our Southern and Western regions. These are all great challenges we were facing, and we're facing them had on. We're showing the precision railroad model works through high volume growth and through low volume growth or decline.
In closing, how we work is not going to change. Precision railroading is our gold standard, and this is crystal clear in our leading -- industry-leading operating ratio. This leadership team knows that we can use the strong base while evolving our operating and service plan to fully realize the results of our comprehensive strategy. We're pleased with the performance of the team this quarter, but in no way are we satisfied. We know as we add our capacity and assets, we schedule the activity as we know how, we'll deliver the results our customers, our shareholders and all of you expect.
So with that, thank you. And over to you, Ghis.
Thanks, Mike. Again, congratulations, J.J., on your appointment. It's well deserved. I'm very pleased with our turnaround, which is demonstrated by our strong financial performance in the second quarter. Starting on Page 10 of the presentation, I will summarize the key financial highlights of this quarter performance. As J.J. previously pointed out, revenues for the quarter were up 9% versus last year at slightly over $3.6 billion. Fuel lag on a year-over-year basis represented a headwind of roughly $30 million or $0.03 of EPS, mostly driven by an unfavorable lag this quarter.
Operating income was slightly over $1.5 billion, up $104 million or 7% versus last year. Our operating ratio came in at 58.2% or 70 basis points higher than last year. Higher fuel prices accounted for 150 basis points of this increase. Also, the new GAAP pension accounting re-class resulted in a 210 basis point increase to the operating ratio in the quarter. Net income stood at $1,310,000,000 or $279 million higher than last year, with reported diluted earnings per share of $1.77 versus $1.36 in 2017, up by 30%.
Excluding the impact of nonrecurring asset sales in 2018 and the impact on deferred income tax recovery from the enactment of a lower provincial income tax rate in 2017, our adjusted diluted EPS for the quarter was up 13% versus last year. The impact of foreign currency was unfavorable by approximately $30 million on net income or $0.04 of EPS in the quarter. Turning to expenses on Page 11. Our operating expenses were up 10% versus last year at slightly over $2.1 billion impacted by higher fuel prices, stronger volumes and operating metrics that still remain below last year's levels.
Expressed on a constant currency basis, this represented a 13% increase. At this point, I will refer to the variances in constant currency. Labor and fringe benefit expenses were $648 million, 8% higher than last year. This was mostly the result of higher wages driven by increased headcount and training cost for new hires, partly offset by higher capital credits and a U.S. payroll tax credit of roughly $15 million resulting from a Supreme Court decision.
Purchased services and material expenses were $478 million, 13% higher than last year. This was mostly the result of higher outsourced services and repair and maintenance costs and higher level of activity in trucking and transload services, partly driven by higher volumes. Fuel expense came in at $436 million or 37% higher than last year. Higher fuel prices accounted for close to $100 million of this increase while higher volumes were a $16 million unfavorable variance versus 2017. Fuel productivity was favorable by 1% in the quarter versus last year.
Depreciation stood at $330 million, 3% higher than last year. This was mostly a function of net asset additions, partly offset by the favorable impact of some depreciation studies. Equipment rents were up 14% versus last year, driven by lower car velocity that increased our car hire expenses and from additional locomotive leases. Finally, casualty and other costs were $108 million, which was 4% lower than last year.
Now moving to cash on Page 12. We generated free cash flow of $1,296,000,000 through the end of June. This is $363 million lower than in 2017 and mostly the result of higher capital expenditures and cash taxes, partly offset by higher net income. Finally, let me turn to our 2018 financial outlook on Page 13. While we need to be mindful of current trade tensions, the demand environment remains solid in a number of different sectors, and we continue to see favorable economic conditions in North America, including positive consumer confidence. We are on track in our plan to hire crews. And on the 16 new locomotives to be delivered in 2018, we have received 10 in June, and we expect 10 more by the end of July. We are progressing on the construction of our aggressive infrastructure capacity investment plan, which is still projected to be completed in the fourth quarter of this year.
We now assume that the Canadian to U.S. dollar exchange rate will be in the range of $0.75 to $0.80. With this in mind and following a solid second quarter performance, we are revising our 2018 financial outlook and now expect to deliver adjusted EPS in the range of $5.30 to $5.45 versus the 2017 adjusted diluted EPS of $4.99. This compares to our previous financial outlook, which was for EPS to be in the range of $5.10 to $5.25. This revised guidance assumes volume growth in terms of RTMs in the range of 5% to 7% for the full year versus 2017 compared to our previous expected volume growth of 2% to 4%. Overall pricing remains solid, backed by our 4% same-store price performance in Q2. On the capital front, we are committed to investing in our business to support safety, service and organic growth. We are further increasing our capital envelope for 2018 by $100 million to approximately $3.5 billion versus our previous outlook of $3.4 billion, mainly due to the acquisition of additional lumber cars and weakening of the Canadian dollar.
This record CapEx supports our commitment to restore our network fluidity and resiliency, and accommodate long-term growth at low incremental costs. Furthermore, we continue to reward our shareholders with consistent dividend returns, and we are on track with our current share buyback program of approximately $2 billion, having repurchased over 13 million shares for an amount of $1.3 billion since last October.
In closing, we remain committed to our agenda and continue to manage the business to deliver sustainable value today and for the long term.
On this note, back to you J.J.
Well, thank you, guys. And before I turn it over to the Q&A, I would like to add a few comments to wrap this up. Our railroaders are energized and are strongly behind the business plan. We are ahead of our turnaround plan. And that's -- we expect from progressive improvement during the second half. We have a strong pipeline of growth opportunities, volume is available. We're investing capacity CapEx in the business. We're investing critical talent -- in critical talent to execute, and we are investing in technology to drive efficiency and input cost leadership.
In regards to our operation, we will have quite the network by the fourth quarter entering 2019 ready to serve our customers and to produce results in our strategic agenda of organic growth at industry-leading costs. We're optimistic of our future, and that's why we revised the 2018 guidance upward.
So operator, we can now turn it over to the Q&A.
[Operator Instructions]. The first question is from Ken Hoexter from Merrill Lynch.
J.J., congrats on the new title. But when you think about your long-term target, now you're at 58 OR. Are we looking at, despite the pension adjustments, are you still aiming to get to the mid-50s? Just want to think about this, because before you launch the big CapEx program, your EPS outlook now is actually above that original target. So it seems like you've more than offset all of that Impact. I just want to understand your thoughts on operations and costs as you think about the top line growth you put in.
Well, thank you, Ken, and thank you for the kind word. On the OR, rather than get, targeting specific numbers, what I'd like to point out in relation to what the industry will be in the next few years, based on exchange, based on price, and fuel, based on economy, our objective is to be in the leading pack of operating ratio, if not the pack leader. So if the industry is able to do slightly better than what we've done here today, then we think we can probably achieve that as well. So in relation to our peer and where the economy and the cost of fuel is, we want to be in the leading pack, and hopefully the pack leader from time to time like in this quarter.
The next question is from Cherilyn Radbourne from TD Securities.
Congratulations, J.J. I think I'm going to pick up on Ken's question there. As he observes, your revised guidance is a nickel higher on both ends versus the original guidance given at the beginning of the year. So then, maybe you can help us sort of think through the moving parts there in terms of the volume backdrop, a more positive pricing environment, and then clearly, you surprised yourselves in terms of the operational performance in Q2.
Okay. So let me start, Cherilyn, and then Ghislain can add a few things. So definitely, when we look at our network, we think our network will be able to execute more volume in the second half. And because at volume, we already had line of sight on that volume, we were able to that volume back into the forecast, because we think we can execute based on the onboarding of capacity that we're doing right now, that's number one. Number two, the pricing situation is slightly better than what we had forecast, what we had in mind back in April, it's not -- our 4% same-store price is indicative of that. And the pricing environment, I think, for all of us is also getting slightly better. And then you have the moving parts on the exchange rate, so I don't know, add, if you want to add some comments.
No, I would reiterate, J.J, first of all, the strong Q2 was obviously something that we are factoring in into our year-end outlook. And as you know, Cherilyn, every quarter, the team sits together with the marketing team, operating team and we look at what we see forward, and we do that exercise every quarter. And this quarter, we did that exercise. And to J.J.'s point, we feel very comfortable that demand is out there. We definitely performed better in Q2 than what we expected coming in into the quarter, and we feel that this capacity, coming in on the infrastructure investments, including the locomotives and the crews, will allow us to deliver the volume growth that -- on a full year basis that we've outlaid, between 5% and 7%, so. Now we have some work to do. This is not going to be a walk in the park. This is -- but this -- for now, this is our best foot forward, but we have work to do to deliver this. But I think as a team here, we're comfortable that we can deliver.
That's right. We had a fairly solid second quarter, maybe slightly better than what we thought we were going to get, when -- the last time we had a call in April.
The next question is from Allison Landry from Crédit Suisse.
Another question on pricing. I mean, I'd say very strong in the quarter. And looking back, it looks like the last time you put up something of this magnitude was in the fourth quarter of 2014. So I'm just trying to get a sense of whether you think the pricing momentum has reached a peak. And I apologize if I missed this earlier, but if you talked at all about what the renewal rates were trending up. So really, just looking to get some color on some of the factors that we need to consider in terms of what might push that 4% up or down in the second half.
Okay, thank you, Allison. So the same-store price for the second quarter was 4.0%. And what we call the forward core pricing, which was based on the renewal of the last 90 days, stood at 4.4%. And regarding the -- what we might expect in the midterm here, remember, our view is really based -- our strategy is based on inflation price -- inflation plus pricing, and also based on having a compounding effect over time. It's a marathon, it's not a sprint. So if inflation today is at 2 point something percent and we have 4% same-store price, that's really what we -- that's really a great -- good range, a sweet spot range for the rail industry. And I think that's a -- we have to be mindful that, that being a marathon, I think that's a range that's -- for it to be sustainable, we need to be mindful of the overall marketplace. So I would describe 4% as a very, very, very solid same-store price. And I think take into account where rail inflation is today, net of the fuel, I think that's pretty good. I know it's...
The next question is from Fadi Chamoun from BMO Capital Markets.
Congratulations, J.J., on the new role as well. So I just wanted to go back to the demand side. So your work that you've done on the network, I'm just trying to gauge, if next year is as strong as this year, say, demand is somewhere between 5 and high single digit, is the network going to be in shape, given the project that you've completed, then what you plan on doing to handle that? And also, if you look at your yard and what you've been doing on your yard, are you going to be in kind of good shape enough to handle that growth? Or is there more that you're not -- that you have to do from a capacity point of view in order to keep that growth momentum kind of going? And related to that as well, your RTM guidance, 5% to 7%, was 1% in the first half, really implies kind of double digit in the second half. If you could give us kind of, 1 or 2 key drivers of that volume as we go into Q3, Q4 and if this is kind of biased toward the fourth quarter, or how does it kind of play out between Q3 and Q4?
Okay. So there's many aspects to your question, but this is a very good question. That's something where we've done the work lately, and we're still going through some of the detail. I will start and then Mike can add up. If you look at Page 8 in our deck presentation today, the one with the map, it gives you a sense of what it is that we're working on, capacity-wise, and also where the business is coming. So when you look at the second half of '18 and what business you would like to onboard in 2019, our guidance for 2019, when we put it up in January will be the trade-off between demand and capacity. So demand, I think, is going to be -- is not really the issue. I think we foresee, been able to have generated demand or could obtain demand that will be keeping our network really busy in Western Canada.
Just think in terms of Chicago, going west especially from Winnipeg to west, busy corridor, a lot of demand and the challenge is not so much a demand, the challenge is how much capacity can we create in time. So what we're building this year, this summer, is not only to meet the demand of November, December. It's really to build a railroad for the first 5 months of 2019. And then after that, Mike is going to provided, by the end of summer of the capital plans for 2019, to build the railroad for the month of May, beyond. And that's where, depending on how much capacity we can execute next year with a capital budget that we will decide to go forward with, that will be why we will put the trade up in terms of RTM growth. So I don't know, Mike, if you want to add about what we're doing in terms of adding capacity, just in broad terms for 2019 in the West?
Yes. Fadi, we'll be looking at, I wouldn't say identical to what we're doing this year, but obviously Western Canada, there's still pockets of resiliency we're going to need with volume growth to attack next year. But what we'll really be focused on also on our corridor to J.J.'s point, from Winnipeg to Chicago. Minnesota, Wisconsin, all through that area is going to the next piece of the bubble as it moves. But other than doing a bit more there, our focus will still be through the breadbasket of the prairies and to the West Coast port. So that's where the majority of the traffic is looking to be growing, and that's where we'll look for the capital programs for next year.
Yes. And in terms of giving you color, it's wet market is conducive to generate volume growth. You have the port business on the West Coast, Rupert in Vancouver. You have Canadian coal mine, a number of them, 3 of them actually, opening up between late this year, early next year, which we have them exporting via the West Coast. You have the Canadian forest product, which is doing very well in pulp and in lumber. We're still not quite able to meet fully lumber business demands just yet. Sand in Northern BC, Northern Alberta, oil drilling activities, [indiscernible] chemical around Edmonton, the grain business, there's the carryover this year is going to be 1 million ton more than last year, and the one that we talked about is really minor, which is crude by rail, which you start commitment, then you start going east, then south.
And they all transverse over those corridors we spoke about.
And how about of the yard capacity? Are you okay now, in terms yard and terminal capacity? Or is there more to do?
Well, Fadi, this year, we're doing yard work in both Edmonton and Winnipeg, 2 major hubs. You know about our work we've done in Chicago. We're bidding in our facilities in Eastern Canada. If anything, we'll be looking at smaller, smaller projects anywhere. Those commodities come together like a Prince George, but we've done work in Thornton Yard. Our yards are in very good shape. They need fluidity to be able -- and to be able to get cars out of their yards onto a fluid network. So that's the big focus, on top of what we're doing right now.
The next question is from Jason Seidl from Cowen and Company.
J.J., your Canadian competitor outlined some potential exposure to the tariff situation and gave investors some color. We do get a lot of questions on that, and I was wondering if you guys could do the same.
Yes, thank you, Jason. And regarding tariff, if we look at what we know, which is what's in place today, which is duty on lumber, duty on aluminum and duty on steel, at this point, there's actually no material effect on our result. Our lumber business is actually up, and we are increasing the size of our lumber fleet, because we don't -- we're not able to keep up with the increase in export of lumber into United States. On the aluminum, what we move is base aluminum. We don't do the fixed semifinished product. So therefore, the 15% duty on [indiscernible] and the like is basically going to be transferred to the marketplace in terms of price inflation. So what that means for CN, we also foresee moving more aluminum for the producer in Québec. And on the steel, it's kind of a mixed bag, because we have customers, as you know, on both sides of the border. And as it turned out, our largest steel customers at CN are in the United States, and they are more likely to benefit more so than what we might lose in the Canadian side. So really the question is, what might happen more in the future in terms of trade with China and with NAFTA, and these things are unknown at this point. So therefore, what I'm saying is, so far, the impact has not been material. And 2 of the 3 commodities, where there's a duty, the volume is actually increasing on the cross-border activities.
The next question is from Brandon Oglenski from Barclays.
Congrats again, J.J. I guess, as you find yourself in the big chair now, can you just give us the postmortem on what happened? Because I think at any other railroad, this would've just been normal seasonality like you guys had a pocket on volume. I think CN created more of a crisis around the service issue and got things under control pretty quickly. So I guess as you look out, and maybe in the context of potential big trade barriers here, do you still have the same CapEx outlook that you should be spending in the low 20%? I think to -- in answer to a question earlier, you said you've given the capital budget to Mike for building the railroad for the next few quarters into 2019, but should we expecting to get mid-single digit RTM growth you have to spend at these levels, too?
Yes. So thanks for the question, Brandon. And so really, our capital budget for next year is really tied to the volume target that we have, right? So the more business we move this year, the more we're going to be consuming the capacity that we're actually laying down right now. And the more ambitious or the more business we think we will have next year, then the more CapEx we need to expand from the month of May to be able to meet the demand of 2019. So it's really -- maybe unlike some of our peers, we do have strong demand. And some of that demand was definitely -- came up, met in the fourth quarter, second quarter. Even in the second quarter, we didn't meet all the demand. So we're still in this partly catching up mode, then we're building resiliency so we can have a decent winter and then building capacity for the business I talked about earlier, that we would like to serve in 2019 and we had very good line of sight.
And some of it, when you get down to the crude, which is the last piece of capital we deployed because that business may not be there 3 years from now, we also ask the customers to commit with what we call take-or-pay agreement. So the capital spend, in our view, in my view, will remain high because -- or higher than others, because we do have volume opportunity that provides a good return on that capital. So that's really in that -- we're in that phase where we have good operating costs. And now for us to really exploit the franchise that we have, we need to deploy the capacity from Winnipeg West or Chicago West so that we don't disappoint our customers, but also that we don't disappoint our shareholders by not generating the EPS, which is available to us from volume and price. So we're already kind of at a different point of the evolution of precise railroading, precision railroading, and we want to be sure we can exploit the line of sight that we have and the volume potential.
The next question is from Chris Wetherbee from Citi.
Congrats, J.J., again. I guess I just maybe wanted to pick up on that a little bit and try to make sure I understand. So the RTM outlook in the back half is pretty robust and pricing, I think, as you said on renewals is invariably north of 4%. So we're getting good volume and good price. When you think about the incremental margins you can generate, I know there's still some service recovery going on. But can you think about sort of the 11% to 17% implied second half EPS growth indicative of the type of incremental margins we should be thinking about going forward for the business? Or are you sort of still in that recovery phase, and then maybe when you look out to '19, things can kind of resume to what you've been before? I know you're well on your way through precision railroading, but I just want to get a sense of maybe how to think about that.
Ghislain, you want to pick up that one?
Yes, sure. So Chris, we are still in the recovery phase, obviously. As I said, we did better in Q2 than what we thought before the quarter. Q3, we've got our work cut out for ourselves because, again, most of all the infrastructure capacity investments won't be online. Some of them will come. Again, this doesn't come in one day. These come on a week-by-week basis, but most of them will come in Q4. So now when we look at incremental margin, and I'm happy to report that if you look at Q2, even without the infrastructure capacity investments, on face value of our financials, you can see that our incremental margins was 35% positive. If you adjust for higher fuel prices and foreign exchange, then those incremental margins were 55% positive. So we're still in a recovery. Again, as I said, Q3, we have our work cut out in Q4. I mean, I think it's a pretty aggressive guidance that we put in front of us. But I think again, I think we're confident. We're happy to report that our capacity infrastructure investments are on time. I mean, they're coming out on time. We are keeping a close eye on it, and we feel that what we have as a guidance and the volume that's coming at us, we feel confident that we'll be able to deliver that. But it's not going to be a walk in the park, but we feel we can do it.
That's right. It's about the construction we're doing right now. So Mike, his comment referred to all the work blocks that we have, which slowed down the network a bit, and the major rain issue that we had in the south of the border that slowed down our network, too. We had some track, which was we had water issues. But as we actually deployed this capital, and some of it is actually just straight maintenance capital, which means that we have to -- we have some downtime on the line of 6 to 8 hours on -- when the crew is working on. As these things get done. After that, we got a very good network and we have the demand out there that we can exploit, so...
Your next question is from Walter Spracklin from RBC.
Congrats, J.J. I guess you made it a pretty easy decision for the Board here. The two areas that you mentioned came in better, Ghislain, but you indicated your operating ratio, ocean expenses came in a lot better in the second quarter than you were anticipating. And J.J., you also mentioned the pricing came in better. Can you kind of drill down on what -- on the pricing side, was it certain segments that came in better? Were you just picking up more business that allowed mix to come in better? What was the factor there? And same way, Ghislain, on the OR, what areas did it surprise on the upside? I'm trying to get a sense of sustainability going forward if these items came in better than what you were forecasting.
So Ghislain will explain in the OR, and I'll finish it up on the price.
Yes. Walter, on the OR, I guess, as I said -- as we said before, our granular understanding of what capacity can do for us is still not there, and we have a team looking into this in detail, and we'll get better at this as we move forward. But frankly, what happened was that our cost and the fact that we now have cruise and locomotive, that much better for us than what we had at the beginning of the quarter. So again, expenses as a margin, came in better. Now expenses, in our view, is still higher than it should. I mean, if you look at our operating metrics on a year-over-year basis, they are lagging. And therefore -- and we knew that, and we told the market that this was going to be the case. And we saw the market that we feel that they'll come more in a flattish range in Q3 and then should be better on a year-over-year basis in Q4. So because these operating metrics were still lagging, our expenses are still higher than what they should be because we need this infrastructure capacity investments because, again, remember that if you don't have the infrastructure, then you have a choice. You either restrain growth or you accept growth, but at a higher cost, so. Now these costs were lower than what we expected, and this is partly why the OR came in at what it came in. And Mike, you want to jump in?
Yes. Walter, one big benefit we had coming out of Q1, we had a backlog of coal and grain. Both those commodities move to the West Coast. It don't necessarily -- now grain does to a degree, but they're not stuck in that tough area of the prairies where we still have no resiliency. So at that time of the year, going to Prince Rupert, going to Vancouver, we're very fluid, so we took advantage of that. We caught up, and that really reduces your operating costs to Ghislain's point, and that drove up our operating metrics also. As we saw some of that, grain softens at this time of the year, we're back in that main corridor where it's pretty tough slugging until we get the capacity put in.
Yes, main corridor being east of Edmonton.
Yes, east of Edmonton, Walter.
And just on price. So we have been doing and now doing what we would call repricing, and the level of which we've been able to do in the second quarter was maybe more than what we thought. We were doing what we call upscaling because capacity being tight, at this point capacity has a value, and that value is recognized by those who want to have more of it. And in some segment, I'm not going to get into detail, but in some subsegment, we're also doing what I would call weekly capacity management, where we manage the mix -- we upscale the mix from week to week to week. So these different things -- these different singles, is difference -- hinged that we grab around us eventually add to a bigger spread between rail inflation and rail pricing.
The next question is from Scott Group from Wolfe Research.
Congrats, J.J. So I understand some of the weather issues in the beginning of the quarter. When do you think we'll start to see the RTMs get to that high single, low double-digit range that we need them to be to kind of hit these numbers? And then separately, on the pricing renewals, I think you said 4.4 this quarter. I think last quarter it was 4.8. I guess I would have thought pricing momentum would still be building. Is that just a timing mix issue, different sorts of customers, maybe just any thoughts there.
Yes. On pricing, when you look at the gold market environment, looking at all the railroads and industrial company, I think, although there's a view, right, that price momentum is building up, I think there may be a lag in perception. I think pricing momentum has been building up longer and earlier that maybe observers think. And therefore, in my view, at least on the rail space, when you look at bulk commodities and carloads and the like and long-term contract, the running rate that we have right now is a very solid running rate. And the proof is in the pudding of the same-store price. If it doesn't show the same-store price, eventually kind of, where is it? So I think taking the view of long-term sustainable and creating compounding effect over time, we feel this 4.8 becoming a 4.4, I think is really -- really reflect the reality of the marketplace, at least in maybe in the rail space.
Regarding capacity, the issue, as mentioned Mike earlier -- Mike, you mentioned earlier, is when you were going west of Edmonton, that network didn't need as much work -- capital work than the one east of Edmonton. And in the second quarter, with having backlog of clean coal undermined, that need to go West to the port and having backlog of grain in Alberta, they need to go West to the port, allowed us to really railroad into place heavy volume in the place where we had capacity. And now as some of these backlog have caught up, for example, we are caught up on moving clean coal from getting online to the coast, then you have to go east, and the east network is not as fluid, because the east network has these major roadblocks in construction to add signings on double-track. And as soon as you got to -- across the border, we had this flooding for 3, 4 weeks while we had water in some places above the tracks, so lots of speed restriction. And on a steady basis, not for half a day, but for days and weeks. And -- so the flooding issue is resolved, but the construction is ongoing. I know our RTM right now for the last three weeks are weak, and that's the reason why they are. So I don't know if you want to give a few more comments to that.
We're planning the latter half of Q3, and then at the same time, we'll see an uptick in grain. Hopefully, some of the coal -- because they're doing some maintenance at some of the mines, also taking this time right now, and then we'll start to see that capacity in that east of Edmonton corridor start to take hold. And so not only will these two be able to take the volume, we'll see the metrics go up. You'll see the trains move faster, you'll see the costs come down. So that will all start to play to Q4.
So back half third quarter is when we should see the RTMs get to that double-digit run rate?
Yes. So eventually, the RTM will get very strong. Pricing is, we talked about it, and the costs will improve as we're able to -- or get the velocity back up in our network. And that will be helpful as well, kind of you have these 3 pillar for the OR and the EPS.
The next question is from Turan Quettawala from Scotiabank.
Congratulations, J.J., on the promotion there. I guess, I wanted to discuss about OR a little bit as well. Clearly, obviously, things are going better than expected here, with regard to your operations. And I understand that there's obviously some issues still that you'll work through as the capacity builds up here. But I'm wondering if you can talk a little bit about 2019. And I know, Ghislain, you've talked about it, in OR with a 5 in it next year. Can you talk about your level of confidence around that number? Maybe, just going into next year, especially as the capacity ramps up. I know fuel can mess it up a little bit, but assuming sort of flattish fuel here.
I guess I'll have Ghislain guide for OR into '19, but he can probably...
We're not going to tell you what exactly. We're not going to guide for 2019. We're going to do that as we usually do it in January. But I can tell you that from -- and reiterating on what J.J. has said a few minutes ago, we are bullish on demand for '19. I think the demand that's out there is real. This demand and this pipeline of opportunities that we highlighted at the Investor Day, between $1.5 billion to $2.2 billion is real, it's there. We've talked to you guys about it on a regular basis. I think that to J.J.'s point, I think the -- we see capital to be in line with that volume, to be in line with that bulliness, so I think we see CapEx to remain similar next year to this year, because again, that volume is there. And frankly, as we've mentioned before, if you don't do that, then your OR will naturally go up, because you will just be slower at the network, and therefore, you will see things that we saw in Q1 and some of it in Q2 where our operating metrics are still lagging on a year-over-year basis or you've got to constrain growth, which is what J.J. was mentioning. So I think that we're catching up, definitely. We still are catching up on employee productivity. If you look at our employee productivity, this quarter, we were down -- if you look at our $1 million per GTM per employee, we were negative 5%. But again, sequentially better than what we were in Q1 because we still have a lot of people that are being trained. We feel that we will recalibrate our workforce some time in '19. And we feel that with this capacity that our OR will come in line in a range of what you guys have been used to see CN deliver.
The next question's from David Vernon from Bernstein.
So Ghislain, you mentioned the $3.5 billion should be the roughly the rate that we should -- that you guys expect to be spending again in 2019, and that's going to keep your sort of cash conversion levels down at lower end of the range relative to the peer group. Obviously, operating ratio's a little bit higher. But I mean, isn't there a third option here? Can't you push price a little bit higher to make sure that you're not necessarily over investing in the network to take on this volume growth?
David, we're pushing on every lever, so we're pushing on price. Where we want to accommodate growth, we want to make sure that we provide good service for our customers. We are happy that we are actually growing organically. But yes, and J.J. mentioned it, at the end of the day, the reason why we have solid pricing are partly the reason why we have solid pricing is because our capacity is a precious commodity, and we're getting as much price as we can. And of course, we're looking at capital to make sure that we can accommodate to grow at low incremental cost and continuing to grow this business. And the beauty with us is we are growing organically. We're growing more than our peers, and we're pretty pleased and bullish about it.
But we're going to spend in lockstep with the growth.
Yes. The capital is to refinish the capacity that's been consumed. The more volume we move, the more we need to replenish the capacity with capital.
Sorry to interrupt. So should we think that, that number then it's also going to a little bit cyclical than in the event that there is going to be a little bit of downturn, there will be some room to trim that budget as well? I would imagine that, that a lot of that resource is also kind of, staff and people on the payroll, that's in the capital line, is that outlook...
David, absolutely. Our plans, as you know, our business is dynamic. Our business changes. Cycles are changing. I mean, if anything, there's more volatility in the environment than there was 10 years ago. So obviously, we do react. We've demonstrated in 2016 that we can react quickly. Obviously, it's easier to react to a downturn than it is to an upturn. We've learned our lesson in '17. And -- but yes, absolutely. I mean, if there's things that have happened, and therefore to J.J.'s point or Mike's point that volumes -- we see volumes being softening, then we'll adjust our capital in line with that, absolutely.
Yes. So we have a baseline based on our view of what the economy and our customers will produce in 2019. But at the same time, we also have fallback plans based on, what the -- the economy might be slowing down or on things on the trade side starting to have material impact. So this is not frozen in cement. Really even though we have -- we put a base plan for 2019, which we're about to put together right now, we revise that once a quarter, and we will adjust accordingly either up or down. So definitely, CapEx isn't related to volume. If volumes slow down, then we don't need as much CapEx to replenish capacity in our next Western network.
The next question is from Ravi Shanker from Morgan Stanley.
J.J., can I just ask you to elaborate on how you see crude by rail as an opportunity over the next 12 to 18 months? Your Canadian peers spoke of potentially doubling their run rate over the next 12 months. Is that something that you guys see as well? And also, kind of compared to how you are looking at the space a couple of quarters ago, how are you thinking about resource allocation, the kind of contracts you're getting and the kind of pricing you're getting in that space right now?
Yes. So maybe first comment is I'll refer to what the performance in crude by rail in the second quarter, where our revenue was up -- the volume was fairly flat. So the increase in revenue was all coming from price, and that was job 1. Job 1 was to reprice crude by rail in a way that you would like to reinvest fresh new capital that requires a return. That was job 1. Job 2 is, if we are able to generate enough capacity on a network, we're talking Edmonton going east and going south, and that -- it generated capacity such that we don't shortchange the grain industry, the potash industry, the lumber industry, I mean, all the other industry used the network, then we will deploy this incremental capacity to move more crude to the United States, because some of these customers, even though they may not be with us long term, are waiting now to pay for a price that generate a return on fresh capital. So when -- rather than giving you how much crude by rail we will move in the second half of '19, my answer is, really, we will look at a book of business that would be long term, and make sure we serve that demand and be a good supplier to these long-term segments and customers, and we will do -- move as much crude by rail as we can, based on how much capacity is left to serve those markets.
The next question is from Benoit Poirier from Desjardins Capital Markets.
Congrats, J.J., for your new role. Well deserved. My question is on -- a follow-up on the crude by rail. Could you talk a little bit about the upcoming grain crop, your expectation and whether you are awaiting for more color about the grain crop before assessing the kind of the crude by rail capacity for 2019?
The grain crop at this point looks -- I mean, it's still early. We can have a drought, we can have excessive rain, and we can have an early frost, many things can happen. But at this point, it looks good, and it looks to be in the last previous average or maybe slightly better. Also remember, the carryover from last year, we already are on August 1, is 1 million tons more than what we had last year. So last year, we had 11 million ton carryover. This year, it's 12 million tons. So I would think that the grain crop coming at us this fall is going to be pretty good. And based on our challenge of last winter and last fall with the grain industries, we want to be sure that we are delivering services for them. So as it relates to crude by rail, it's really not about crude by rail demand, it's about what I just said here, how much capacity can we build this summer. And Mike can add to that. But it's -- we're actually not so concerned about the overall demand on network for 2019. That's why we're talking with the capital program that will be on the high side. And we don't want to take capacity from those that are going to be growing grain for the next 50 years in the prairies and put that in the crude business if we can't serve the grain this fall. So it is a trade-off that we talked about. And also, that's why I talked about how we price crude. Crude pricing that supports new fresh capital dollars. I don't know, Mike, if you want to add about the grain and how we're getting ready for the next crop?
Yes. No, I mean, our mission, Benoit, is to deliver every kernel or seed or whatever it is that's out there. That's a big item for CN. So I'll go back -- J.J., I think, spoke about it earlier, about any opportunity for capacity that we see, and we played this in Q2, and we saw, by week by week capacity open up, we jumped on it and we alerted our, in some cases crude customers, other customers we could see it coming and then we acted on that. We'll continue to do that. So Ghislain spoke on it right now, we're doing so much capacity, we're not exactly sure on a granular level what the exact outcome's going to be. We feel confident it's enough, but if we see capacity show up, we will definitely go after whatever car load is out there and if it's crude, it's crude.
That's a good point. I forgot to mention that, but in the second quarter, within the executive team, and the senior guy on the commercial side, we were managing capacity week-by-week. Since we had a window of 2 weeks of some capacity going west and going east, where the sales force out there, basically securing orders to use up the available window capacity, and that was one of the way we've actually produced pretty good volume in EPS in the second quarter is using what we have, to be more nimble. As an industry we need to be more nimble to use capacity when capacity window opened up.
And we've got a pretty strong supply chain group that aligns between both operations and sales and marketing, that feeds into us every piece of intel we can use to get -- to fill that capacity.
Very tight inworking between the network group and the marketing group.
The next question is from Brian Ossenbeck from JPMorgan.
Congrats J.J. on the promotion. Just a quick one on the 5 major projects. You mentioned they were all completed on time, the CapEx went up a bit on FX, but how was the overall cost profile been versus the budget, and if you feel like you've got the construction capacity, labor workforce to continue spanning at the current pace, or pace that you expect for the next couple of years?
Hi Brian, it's Mike. The five projects, completed on budget. We don't see anything presently standing right in our way to not compete in the other projects we have. Things can happen between now and the end of project completion. But from a permitting standpoint, from a manpower standpoint, we'd got the resources. It's been a really big project for us, just to get the materials and logisiticate that throughout all the other commodities that we move, but the engineering team, along with our operations team have worked hand-in-hand with Ghislain and the finance and supply procurement people, very comfortable that we'll come in on budget. He's staring at me right now. We'll come in on budget, on time and with the projects that we said we would do. And we track them extremely close from me on down, it's a weekly exercise with everybody, so. I hope that answers your question.
The next question is from Seldon Clark from Deutsche Bank.
I just wanted to get to -- back to CapEx for a minute. Can you give as an idea of what percentage of CapEx is designated for growth versus maintenance? And just, I'd imagine 2018 has some catch-up maintenance projects, so I kind of just curious as to why CapEx shouldn't come down next year, kind of longer term as those maintenance products kind of go away.
Okay, Seldon, this is Ghislain. I can give you $2.5 billion inflow. If you look, we had about $1 billion on capacity, and if I break that down, you have about $500 million related to infrastructure capacity investments, $400 million that's in Western Canada, that Mike and J.J. have alluded to, and there's another $100 million of infrastructure investment that we need in our intermodal terminals. And then, so that's $500 million, and then we had another $500 million for equipment, which is basically locomotive, cars and intermodal equipment. And then there is some of the lumber cars that I referred to in my remarks. On basic infrastructure maintenance, that's $1.6 billion, and then growth and other maintenance, it's $500 million and then PTC, positive train control, is $400 million. So that's the rundown of our $3.5 billion CapEx envelope, as we've said...yes, go ahead.
I guess my question was just more in terms of like, how much of that $1.6 billion in some of those infrastructure maintenance was really catch-up, because you're obviously caught a little off-guard towards the end of last year, so I'm just trying to quantify that.
There's no maintenance, that's catch-up. The maintenance, we've been ongoing, providing maintenance. Remember in 2016 when the volumes, our volumes were down 5%. Some of you guys wanted us to reduce basic maintenance, and we didn't do it, and it was a good decision because, for my team, it was easier to get the work blocks and when you look at the installation unit cost of putting ties and rail, it was actually down 15% to 20%. So we are not catching up on basic maintenance. We will not catch-up on basic maintenance. We got caught with a lot of volume coming at us in '17 and we're catching up on capacity. Capacity meaning infrastructure, sightings, double track, mostly in Western Canada, and on crews and locomotives.
And on our core mainline, these are 100-year investments.
Yes, maintenance is safety, velocity, operating ratio.
Direct capacity addition is citing double-track figure [indiscernible] yard and restacker.
The next question is from Tom Wadewitz from UBS.
J.J. congratulations to you. I was just a little surprised the Board took so long to figure it out. But I guess, in all seriousness, congratulations. Well deserved.
Thank you, Tom.
The question I had, I don't know if this is for you, J.J. or Mike, but looking at one of your slides, it shows the Western corridor. Do you think, when you look at Edmonton to Winnipeg, that ultimately that needs to be fully double-tracked? And when you think about it, just wondering if you can offer us some thoughts on what's the mileage between those 2 and kind of what percent is double-track? And how do we think about that longer term? Is that of 5 or 10-year project, assuming that ultimately needs to be double-tracked?
We'll give that to Mike, he's my top guy. He was born in Winnipeg, so he knows his backyard really well.
Absolutely. Before a pass this earth, I'm hoping to see the majority of it the double-tracked. That is, from where our commodities go through, so it's arctic bridge, it's of the toughest of weather conditions of any class 1 railway, that will be every year, we'll go back and we learn, we will not stop even when volumes go down. These are, again, 100-year investments we're making through there. I don't know the second question you had, and if that answers all your questions?
It's 800 miles and change, and probably, off the top of my head, prior to these 5 pieces of double-track we're doing this quarter this year, there's probably less than 100 miles that's double-tracked. 50 of it from my hometown in Winnipeg, to a place called Portage la Prairie, and then for some reason, in the 70s, we stopped. But we had a pretty solid plan, a strategic plan -- not regardless of the volume, but any volume that comes on that, over the next few years, we will always go back in and do another piece of double-track, if not more. Again, this year five, next year we're, if volumes continue, we're looking into probably another 4 to 5 stretches.
Okay, I mean, is that like a 5-year plan, or 10-year plan? Or just -- we got to see what volumes do?
It depends on volumes obviously, but it's a forever plan. This is really in our breadbasket.
It's a long-term plan. The volume pace of the CapEx, so it depends how fast that the CapEx come in, so. It's a long-term plan, that we pay for the adding capacity is, how much volume we have from year to year, to pay for the capital deployment. So there's not a specific time line, it's more volume-related than anything else.
This concludes today's question-and-answer session. I would like to turn the meeting it back over to Mr. Ruest.
Well, thank you for joining us today. We're really proud of the team results and how we put the quarter together. It was a challenging winter, it was challenging also from a -- for our customers, the people who do business with us. We did it -- we have a very strong month of May and the month of June. July, we're -- we have this major construction here East of Edmonton, but as we're making more inroad with this work blocking construction, then we'll pick up velocity, and we'll be able to meet more demand. So demand is strong. Pricing looks good. The morale is very strong. We really work as one, the team is energized and we're there for that reason, we've increased our guidance because we're optimistic about the future here ahead of us. And we also, regardless of the discussion back and forth on trade, no material impact yet on our volume, and we think everything being equal, things coming together the way they should, 2019 should be a very solid year as well. So thank you. Operator, this will conclude our call.